The author is a Forbes contributor. The opinions expressed are those of the writer.

Loading ...

Loading ...

This story appears in the {{article.article.magazine.pretty_date}} issue of {{article.article.magazine.pubName}}. Subscribe

(Photo credit: Wikipedia)

Roughly two and a half years ago, a well-known analyst called for a massive wave of defaults in the municipal bond market. Never mind that when she made the call she had little or no experience in evaluating municipal bonds. Never mind that when she made the call she had just left her former employer, formed her own company, and was now selling research on municipal bonds. The market listened and, in late 2010, the muni market sold off. Since bottoming in late 2010/early 2011, the muni market has done nothing but rally. In spite of this, worries about massive defaults persist.

In March 2012, Moody’s Investors Services published a report on the municipal bond market from 1970 to 2011. The report is data-rich and comprehensive. It included all muni bonds that Moody’s had rated during that period. The number of bonds it rated during the past decade averaged 16,000 to 18,000 each year.

During the entire 42-year period, of the tens of thousands of bonds ever rated by Moody’s, a total of 71 bonds defaulted. Let me repeat, seventy-one. Of the seventy-one, five were general obligation bonds and 66 were non-GO (revenue) bonds. Of the revenue bonds that defaulted, nearly 72 percent were housing and hospital/health service bonds. The categories of education, water/sewer, utilities, etc. represented small minorities of the defaults. For example, during the entire 42-year period, only one sewer/water bond defaulted. Let me repeat, one.

According to the report, of all the dollars that had been invested in the 71 bond defaults, investors received an estimated average of 65 percent of their money back. Of course, the recovery experienced by an investor in a specific defaulted bond might be lower or higher than this average. For example, the report identifies that investors in particular hospital bond recouped 10 cents on the dollar. Investors in a different hospital bond recovered every penny of monies invested.

Assuming that one has broadly diversified municipal bond holdings, the threat would not seem to come from a biblical-scale wave of defaults. (I must admit that we have no data on muni defaults during biblical times.) The bigger threat to a broadly diversified muni portfolio would seem to be the typical market cycles of run-up followed by correction followed by run-up.

As was mentioned earlier, muni bonds had been on a tear for two years – AKA run-up. Late last year, they entered a corrective phase. Investors should be asking whether this is this part of a bigger correction or is this simply an intermediate sort of thing. Whichever it is, the conversation is about the “trade” and not about waves of defaults. Nonetheless, this recent correction has given the prophets of doom an opportunity to say, “The end is near.”